The economy

Waiting for the chop

The economy has survived austerity thus far this year thanks to housing, but the “sequester” could change that

WHEN Barack Obama and the Republicans in Congress agreed on January 1st to let a payroll tax cut expire and tax rates rise on the rich, they rolled the dice with the economy. They in effect bet that America’s recovery was solid enough to withstand higher taxes and spending cuts, including a “sequester” due to take effect on March 1st. At 1.9% of gross domestic product, that is a contraction second only to that of Greece among rich countries this year (see chart 1).

At America’s biggest retailer, it looked at first like the gamble had not paid off. “Where are all the customers? And where’s their money?” one executive at Walmart said in an e-mail dated February 1st obtained by Bloomberg News. February sales to date “are a total disaster,” another wrote on February 12th.

But the company painted a less dire picture on February 21st, when it reported its earnings. While sales had indeed flattened out, the culprit was not, it appeared, tax increases, but delayed tax refunds (also a result of the January 1st legislation). Customers last year cashed $4 billion worth of income tax refunds at Walmart’s shops, but so far this year had cashed only about $1.7 billion. Presumably when the refunds come through in March, so will the usual spending they bring.

For now, the economy seems to have shrugged off austerity. GDP, which stalled at the end of 2012 because of one-off factors including Hurricane Sandy, now seems to be growing at about a 2% annual rate, Ben Bernanke, the Federal Reserve chairman, said on February 26th; that is the same, uninspiring pace it averaged throughout 2012. In effect, the economy is caught between headwinds and tailwinds that have roughly cancelled each other out. The headwinds, besides the government’s austerity, include a rise in petrol prices that could trim 0.2% off this year’s GDP by depressing consumption.

On the positive side is the spreading recovery in the housing market. In January sales of new homes shot up to their highest level since 2008. The inventory now equals just 4.1 months’ sales, an eight-year low and a powerful spur to new construction. The economic benefits go well beyond bricks and nails. Rising home prices and a stockmarket at near-record levels added $4.8 trillion to household wealth last year, reckons Paul Dales of Capital Economics, bringing it to around $65 trillion, close to its pre-crisis peak. He figures the “wealth effect” of stable stocks and modestly higher home prices should lift consumer spending enough to add 0.7% to GDP this year (see chart 2).

Rising home prices should also loosen the supply of mortgage credit by making default, foreclosure and litigation less likely (see article). John Williams, president of the San Francisco Fed, recently spoke of a virtuous circle, “with sales volumes growing, home prices increasing, and foreclosures coming down”.

Yet it is far too soon to declare the experiment with austerity a success. The sequester still looms, and its effects are unpredictable. Mr Obama and Republicans agreed to the sequester in 2011 purely as a spur to negotiate a more rational plan for reducing the deficit. As The Economist went to press, no such bargain looked likely to materialise in time to prevent it coming into force on March 1st.

The sequester was originally designed to slice $1.2 trillion from spending over a decade. The initial instalment is a cut of $85 billion for the seven months until the end of September, though that will reduce actual spending by only $42 billion since some money approved in one fiscal year is spent in the next. Most entitlements, such as pensions and health-care, are excluded, which makes the reduction in the rest more severe: 13% in defence spending for the next seven months and a 9% cut to other domestic discretionary programmes.

After long insisting that the sequester was too horrible even to contemplate, the Obama administration has finally begun to give details of its implementation. The cuts will come primarily through reduced grants, such as for Head Start, an anti-poverty programme for preschoolers, and staff furloughs (unpaid days off). Since the government must give at least 30 days notice of furloughs, and most agencies have not yet done so, the public may see no impact until April. With luck, the sequester may have been unpicked by then.

The most directly affected will be federal employees. Marcherie Williams, who works for the Internal Revenue Service in Philadelphia, complained about the “uncertainty” the sequester is causing for her and her co-workers. In a survey of its members the National Treasury Employees Union found that 63% expected to eat into retirement savings and 57% would take on additional debt. Regionally, Maryland, Virginia and Washington, DC, will be hit hardest, as they are home to the highest concentration of federal workers and contractors.

The most damaging effects may come from cutting back on federal services. The Aerospace Industries Association, a trade group, reckons the Federal Aviation Administration’s plan to furlough most of its 47,000 employees by one day per pay period could cut air traffic by 5% to 10%. This would reduce the fees paid to the FAA by airlines, negating most of the beneficial impact on the deficit. Cargo flights, often made at night, could be hurt the worst.

The National Cattlemen’s Beef Association claims the furloughing of meat, poultry and egg safety inspectors will affect 6,300 establishments and cause $10 billion in lost production. Likewise, the furlough of customs officers could result in huge delays at border crossings, crippling the supply chains that are crucial to the automobile industry, says one trade group.

Such predictions must be taken with a grain of salt since it is in each industry’s interest to sound the alarm. But the underlying point is correct. If you wanted to cut the deficit in the most damaging way, you’d choose the sequester.